The Great Simplification with Nate Hagens - The Speed Bump | Frankly #12

Episode Date: October 14, 2022

Despite the improved standard of living that modern finance has enabled, it has also created an unsustainable economic system rife with systemic risk. Recent trends in debt, monetary inflation, interest rates and U.S. dollar hegemony are accelerating us toward a point of biophysical reckoning when the system can no longer function as intended, and nearly everyone's financial comfort level will suffer in the ensuing recalibration back to reality. This week's Frankly is a reflection on the financial industry's history of accelerating through crisis after crisis, each time sowing the seeds of the next, bigger crisis.  Is the mother of all speed bumps just ahead? For Show Notes and Transcript visit: https://www.thegreatsimplification.com/frankly-original/12-the-speed-bump To Watch on Youtube: https://www.youtube.com/watch?v=hYQDEa99pYU

Hello, good humans. I have Frank here. Frank say hello. We're doing a frankly, and you're going to start out of my lap, but now you better get down because dad is going to talk about some adult stuff. Okay. Today we're going to talk about finance. And just as we are energy blind, we swim in a sea of finance since I've been alive. And basically, modern society has financialized the human experience. experience. We've done this in three ways. Number one is we've parsed all of the rich fabric of our ancestral lives into one metric, dollars, or euros, or yen or Renbingbee, or pound sterling. We measure our self-worth by our net worth. Maybe not everyone listening to this, but generally in society, we ascribe success.

and value to people that have money. Money is power. We've financialized our cultural scorecard. The second way is we've also financialized growth and our expectations and institutional rules around money and money is what lubricates the system and changes our expectations for the future because we always think we will have more or the whole pie will grow. And we measure the pie or our success by money, digital electrons and linen paper in our pockets. It's this third way that we financialize the experience, which is going to be the subject of this podcast, which is that we are using finance to solve or kick the can of the problems that finance created. So it's kind of like a slow boiling frog that we're in a pot of hot water economically,

but we don't feel it because we're using financial responses, too big to fail, artificially low interest rates, quantitative easing, guarantees, rule changes, expansion of debt, etc. in order to avoid facing the problems of previous installations of those efforts. That's going to be what I'm going to talk about today because I think at the core of the logic of the great simplification is this divergence between our financial representations of reality and our underlying technological material and energy reality. So what is, finance. So humans historically have faced different frameworks of our money and our worth. And for the longest time, we used the ecosystems and hydrological flows of the sun to represent the scale of our

society. And then a couple hundred years ago, we started to farm vertically, in addition to horizontally and we accessed these stores of one-time energy and materials that deplete. And we access the best first and then the next best. And eventually what's left is the lower quality hard to get at. On top of all this, we've overlaid financial markers until around the 1950s. You could flip a coin. You wouldn't know whether prices would go up or down the following year. because our economy was growing so fast with seven or eight percent oil growth,

lots of ideas, lots of open spaces that we needed more and more money to catch up with this extraction profile, this Gaussian profile of non-renewable natural resources. But since the 1970s or so, that dynamic has changed. Our productivity, our growth peaked 50 years ago. We're still growing, but we're growing at a lower pace. but what we're doing is we're adding more financial claims every single year that are the same claims on a shrinking pool of natural resources. So where does money come from? Well, most teenagers have the talk about where babies come from. We don't get the talk about where money comes

from. Up until around 2005, 2007, 95% of our money came from commercial bank. when they made a loan. And that still happens, but since most countries are operating a budget deficit, they actually create money when they run a deficit. So right now, around 80% of our money comes from commercial banks making a loan. And about the rest of it comes from governments deficit spending to meet budget deficits by creating more currency. When this money is created, the same amount of coal, oil, fossil water, trees, etc. exists. So we are diverging from our monetary representations to our underlying

biophysical reality. So what is this situation? Okay, let's take, for example, a family where you, listener, as the household of this family, make $50,000 a year. Well, right now you owe the bank $175,000. Okay, so not a great situation, but manageable. But here's the challenge. This is what's happening today. You continue to consume more than your income. So you need to borrow more money from the bank every year on top of the 175 year already owe.

You're now growing that debt three times faster than you're growing your income. And oh, by the way, the economy is starting to slow and you're not getting the raises that you used to and you might actually get laid off. Not only that, but the interest rates used to be 1% or 2%, which for 175,000, it's no big deal to pay that interest. But now at, for example, 5% interest, the interest on what you owe is becoming a big chunk of your income. and that is a problem. The other part of this is that's your family, but you have a network of families. The Homo Sapiens Corleone family and all of your distant cousins and brothers and grandchildren, you owe some of them money, some of them owe you money.

And if some of the grandchildren or distant cousins go belly up, it's no big deal. but if some of the patriarchs and matriarchs of the family go bankrupt, there is a ripple effect. So this family, you may not be surprised to hear, is a representation of countries around the world. 50 to 175,000 is 350%. The total global debt is 350%. And now this has been increasing over decades. So it hasn't really been a problem. We've talked about nuclear war and risk homeostasis. That also applies to a financial reckoning. We have not had a financial disaster. So therefore, it's never going to happen is not exactly sound thinking. We came very close in 2009. And we came close again in 2020. And by the way, the answers or the

responses in 2009 in 2020 were to use central bank bazookas and huge guarantees that are now, you know, we've kicked the can so many times that you could argue that the road is full of cans. So what are the risks? Well, first of all, we run the risk as higher interest rates of creating lots of zombie companies and zombie governments. Zombie government is or a company is one that has enough income and revenue to pay their employees and pay their wages and their supply chains and their interest on the debt, but they cannot service the debt. So they have to get perpetual help or low interest rates or new debt in order to stay solvent. They're not bankrupt, but they're insolvent.

And this applies to corporations and to entire countries. Another risk is our entire pension model is built on growth. Our pensions generally have a model where they expect 7% return in perpetuity. And if they don't earn that 7% then they're in a deficit and they're underfunded. Okay. So even in the massive increase in financial markets in the last 15 years, a lot of pensions are underfunded. Take, for example, the state of Illinois, they are only 30% funded, which means that if they're expecting a 7% return, they have to do three times that in order to stay funded. They have to earn 20% or 21%.

So what ends up happening is we've had this incredibly stable low interest rate regime for the last couple decades where interest rates were very low and they didn't bounce around a lot and they didn't go up a lot. So in this time, a lot of financial people and remember around 30 to 40 percent of our economy is the fire sector, finance, insurance, real estate. and a lot of them use gearing or leverage. When things are stable and interest rates are low, they can borrow five times their money and invested and have a very low cost of capital. So a lot of pension funds did this and they're still underfunded. So what are the pathways for the pension system? Well, number one is they can boost productivity.

We can have some new technological invention for society. and continue to grow and maybe get back to some of the higher five or seven percent growth rates of 40 or 50 years ago, because that would allow stocks and bonds to do well enough that we would eventually have these pensions fully funded. The second way is to increase new deposits and get new people to pay into the pension program, which is kind of another word of saying that it's a Ponzi scheme. And then the third way, which I think is, is by far the most likely outcome of this is there's going to be haircuts, there's going to be

defaults, there's going to be people that get 30% or 50% of their eventual pensions. This is not good. We fully expect all these monetary claims that we have in our bank accounts that will one day be paid off and we don't have the resources to pay them off. Energy and material, money is a claim on energy and materials. And we keep growing our money, but we don't keep growing our energy and materials. And in fact, I could argue and will argue that oil peaked in 2018. What's another risk from this? Interest rates. We've based so many things in our economy around two or three percent interest rates, including mortgages. Now mortgages are spiking. So people that were in the real estate market, bought a house. Now, if you want to buy a house, the mortgages are 5% higher than they were a couple

years ago. And this means the house and the interest payments and everything costs more. The interest rates are also going to impact, for instance, energy investment, upstream investment into oil and gas infrastructure or utilities or lots of things. For instance, renewable energy, the largest component of the cost of renewable energy is the interest payments. So if all of a sudden we shift from 1 to 2% rates to 5% or 6% rates, the net present value of the projects no longer make sense because it's going to be much higher interest. Finally, the other risk is that the family example I gave of 50,000 to 175,000,

This is the whole world. And so what ends up happening, some of those cousins or grandchildren could go belly up and the rest of the system stays intact. But if some of the big players go belly up, like the UK Sterling, which right now is going through a pension crisis and a funding crisis,

and the UK government is bailing them out, well, eventually the bank in this example, in the private example, where we owe the bank, $175,000 and our income is 50. In the world example of 50 to 175 being the whole global economy, the bank is the financial market. And at some point, the financial market will start to lose trust in central banks and government's ability to guarantee and service these increasing financial claims on reality. So we could head for a too big to save moment in lieu of a too big to fail moment

15 or 14 years ago with Lehman Brothers. There are probably other Lehman Brother risk scenarios on the horizon because what's happening is the USA in addition to being one of the wealthiest countries in the world. We've used more fossil fuels than any country in the world. We also have have the seigneurage, which is the economic benefits that accrue from having the world's reserve currency. So a lot of countries in the world borrow money denominated in dollars. And right now the dollar is on this rocket launch rise of getting stronger and stronger. And what that means is that if your debt is denominated in dollars, you owe more money. So there's a lot of countries in the world that are under extreme financial duress right now. And this Russia-Ukraine situation

plays into this as well because a lot of those countries are really financially strapped. But if we head towards not only a multipolar military world, but a multipolar economic world where the United States is no longer, the United States dollar is no longer the world reserve currency, there's a ready talk of Russia creating a different payment system for the bricks. And all of a sudden, these countries possibly could say, you know what, I'm not paying and I'm going to be part of this new system that actually is going to guarantee me natural resources, energy, and commodities, which is what we really need. So there's a big risk there of a real cluster in the global financial system. I think it's inevitable that we will have a recalibration of the global financial market,

including potential new currency, currency reform, a new Bretton Woods. And I don't like to make predictions with my work. I'm trying to describe rather than predict. But personally, I'm very confident that finance and the problems with humans, financializing the human experience to build the biggest bubble in the history of the world will be the story of the coming decade. So how could I be wrong? Well, I'm not wrong that energy and materials underpin society and that we create

monetary markers and overlay on top of that. I'm not wrong that productivity peaked 50 years ago and that economists don't attribute productivity to our growing energy and materials, but rather to capital and labor. I'm not wrong about the ecological impact of our situation. A standard neoclassically trained economist would say that I'm wrong because money doesn't matter. Money is neutral to our economic output. Debt makes companies more productive, so debt is also neutral to our GDP situation. They would also say I'm wrong because capital and labor and some productivity factor akin with some natural law means that humans will naturally innovate and grow over time.

Where I would disagree with them is that energy is special. A barrel of oil is four and a half years of my work, which means that a vast majority of our productivity is due to us drawing down this ancient sunlight bank account and treating it as if it were interest. A modern monetary theorist would correctly describe where money comes from. They get that part of it right. But they also use the same macroeconomic logic that is energy blind, that a country can continue to create and print money and can never go bankrupt. And they're right about that. That is true.

But what they're wrong about is, number one, the rest of the world may not trust that that country can pay back their debts. And number two, that energy is what is the core driver of this, energy coupled with technology, and energy is soon to be depleting. So where I could be wrong is we might come up with some massive new productivity that kicks the can further and forestalls this economic financial reset. And that's possible. I don't see anything on the horizon with that amount of scale that could do this. In my opinion, the speed bump ahead of us financially will be the onset for the great simplification for a much, much larger percentage of

humanity. I think we are going to try to forestall this by printing more money, more guarantees, issuing more debt, and trying to inflate our way out of this problem. But the markets may preclude that if interest rates continue to go up. We are probably headed for yield curve control, which in addition to quantitative easing, we take a certain duration of interest maturity, like five years or 10 years, and we target the cap of rates that that could be. Japan is already doing this. They're buying all the long-term Japanese debt to keep a cap on their interest rate. But we have countries issuing debt and then buying their own debt. This is a recipe for disaster.

So what to do? As an individual, if you made $50,000 a year and you were afraid a little bit for your job and you owed the bank $175,000, what would you do? You would probably tighten your belt. You would probably change some behaviors in your life. you would probably try to focus on what is most important and get rid of some of the extraneous discretionary things in your life. The good news is that you have a house, you have a great family, you have knowledge and skills, and you're creative and can learn and adapt, and that is the same

good news for our culture. We have all those things. This doesn't have to be an absolute disaster, but it's the delta between this reality that I'm suggesting and our cultural expectations and the fact that central bankers, government officials have absolutely no plan for this financial speed bump other than to kick it further down the road. So again, on this frankly, this wasn't so much a heart-based reflection of my hopes and dreams for society, I'm trying to describe the severity of a financial roadblock that's ahead of us. And I don't see a way out of it. I think we'll try to inflate our way out of it, but ultimately we're going to have wider and deeper poverty. And I expect a 30%

across the board pay cut for everyone in society on average, including me. And that's kind of what I want to help people understand and prepare for, both as individuals, as communities, and as governments. Thank you. I'll see you next week.